A Quixotic Crusade for Common Sense?

A Path to Getting Paid to Wait While Serving Up Critical Diversification Needs

Yet after the world’s most valuable chipmaker smashed expectations with its blowout report Wednesday, the AI party is one nobody can afford to miss. Short interest is nearly nonexistent among tech behemoths. …

For active managers, the pressure is getting more intense by the day to ride the upward momentum across tech-powered indexes like the S&P 500 and Nasdaq 100 …

In turn, the Nasdaq 100’s price-earnings ratio climbed above 30x…[a] figure with few precedents outside the late 1990s dot-com craze…. Among hedge funds, the latest 13F reports revealed another increase in the share of ownership of the group. Retail traders are also driving the action, with demand for bullish options reminiscent of the pandemic-era trading boom.

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So said Denitsa Tsekova and Carmen Reinicke in their superb article Bubble Hunters on Wall Street Crushed as AI Trade Conquers All. What their Bloomberg piece did better than any other we have seen is encapsulate the powerful confluence of forces that have sent the “AI Complex” soaring. Let’s summarize in three bullets:

You definitely can’t short AI and stay solvent
If you’re a long-only active manager and you are not in AI, you have been or are about to be sacked
Retail speculative activity on AI names is reminiscent of the behavior seen in 2020 and 1999

In our view, these are some of the least appealing reasons we can think of to own a stock. For a sense of sheer scale, we provide the market cap to GDP of the 30 largest American companies below. America’s top 30 made a new record high in December of 2021.

In 2022, the popular 60/40 diversification strategy had its worst performance since the Great Depression, and investors learned….nothing. Off to the races again.

Long-time KCR readers are familiar with our work on the arithmetic issues facing today’s “Nifty Fifty”, the bubble in junk stocks that peaked in 2020, and the increasingly severe risks to investors from concentration.

We are obviously not alone in these concerns. We urge our readers to peruse the brilliant work of the wonderful folks at Capital Group and Clearbridge. While slightly different in construction, both pieces use clear charts to explain that while this recent mega-cap run may be fun, the importance of diversification has rarely been higher.

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KCR will try to use the one simple chart below to highlight the major problem with the 30 mega-cap stocks that have single-handedly soared since the start of 2023.

Let’s start with the navy blue bars and move from left to right.

First bar: the sales of the 30 largest companies in the Russell 1000 Index have historically averaged 26% of the index’s total sales [total sales of the 30 largest stocks divided by total sales of all stocks in the Russell 1000 index]
Next navy blue bar, those 30 largest companies typically averaged 39% of the index’s total profits
Last navy blue bar shows that the 30 largest firms are typically valued at 2x price to sales

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FAQ

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As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade. If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you. KCR also offers a wide range of easy-to-use but sophisticated tools. Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
Kailash Capital Research, LLC ’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias. L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.

Sources

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The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital Research, LLC and its affiliates (collectively, “KCR”) shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of KCR. In preparing the information, data, analyses, and opinions presented herein, KCR has obtained data, statistics, and information from sources it believes to be reliable. KCR, however, does not perform an audit or seek independent verification of any of the data, statistics, and information it receives. KCR and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction.

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